In the first of a series, Amanda White examines the behavioural biases that afflict all clients, and how financial planners can overcome them.

Sit in any economics class and the teacher will begin with the same words every time: “Let’s assume…”.

Most economic theories begin with a number of assumptions, one of which is always assume a “rational” investor. What the traditional theories fail to spell out is that an “investor” is also human, with many foibles, which should be enough to dispel any theory. (It is like physicists assuming a “frictionless surface” when no such thing exists.)

This could perhaps explain why economists are embracing behavioural finance, and the recognition that investors are not rational.

Behavioural finance combines psychology and economics by exploring how behavioural traits such as overconfidence, representativeness, anchoring and loss aversion impact on investors’ behaviour.

Way back in 1955 Herbert Simon, from the Carnegie Institute of Technology in the US, raised this seeming flaw in economic theory in his article “A Behavioural Model of Rational Choice” pub­lished in The Quarterly Journal of Economics.

‘Biases are reflective of survival techniques in the savannah when we were hunters and gatherers’

He said: “Traditional economic theory postu­lates an ‘economic man’ who, in the course of being ‘economic’ is also ‘rational’.

“This man is assumed to have knowledge of the relevant aspects of his environment which, if not absolutely complete, is at least impressively clear and voluminous. He is assumed also to have a well-organised and stable system of preferences, and a skill in computation that enables him to calculate, for the alternative courses of action that are avail­able to him, which of these will permit him to reach the highest attainable point of his preference scale.”

Behavioural finance holds that knowledge, skill and preferences are not necessarily rational, and that humans are wired to produce biases in their behaviour.

While psychologists have been exploring these biases in business for more than 50 years, it has not been until the past 20 years that economists have seriously recognised behavioural finance as a research stream.

In 1979 an American psychologist, Daniel Kahneman, wrote a paper called “Prospect Theory: An Analysis of Decision Under Risk”, which really opened the floodgates on the challenge to “rational” investing behaviour.

More than 20 years later, in 2002, Kahne­man won the Nobel Prize for Economics for this research, which integrated insights from psycho­logical research into economic science, especially concerning human judgment and decision making, and thus giving credence to behavioural finance.

David Gallagher, associate professor of finance in the School of Banking and Finance at the University of New South Wales, says while it is still not a universal school of thought among finance academics, behavioural finance challenges tradi­tional finance theory by arguing investors exhibit cognitive biases, which influence their behaviour and so the decisions they make in markets.

“Behavioural finance argues that investors do not necessarily operate in a rational manner, and that psychological, social and anthropological fac­tors impact on financial decision making,” he says.

The argument seems quite persuasive. After all, overconfidence, regret, hindsight, under-reaction, and herding, or following the crowd, seem to affect other factors of our lives. What else but safety in numbers could explain 80s clothes as the fashion of choice for Gen Y? It was bad enough the first time around.

John Dani, ipac’s national manager for advice development, believes human cognitive weaknesses predispose us to being poor managers of money.

Worse still, these are caveman instincts, hard-wired into our mental processes.

“These biases are reflective of survival tech­niques in the savannah when we were hunters and gatherers,” he says. “Herding is a safety mechanism. It is very dangerous to stray out in the wilderness. The same applies for consumption now; it dates back to when we had to build reserves in our bodies for leaner times.”

Behavioural finance explores these human bias­es, or impulses, and applies them to both markets, and the behaviour of investors in those markets.

Managing director of global bond manager Pimco, William Gross, says markets move to un­dervalued and overvalued extremes because human nature falls victim to greed and/or fear.

But while these psychological phenomena may well be true, is there any way to overcome these seemingly natural instincts? And what does it mean for financial planners not yet ready to undertake a PhD in finance or psychology?

From a practical point of view, these studies are important for planners because they aid with understanding their clients better.

Just as it has become important to do in-depth profiles of clients’ decision-making around other preferences – recreational, personal, and business – so too do natural human biases help form the profile of clients’ spending, and saving, patterns.

In 2006, BT Financial Group and the Univer­sity of Western Australia, undertook one of the most extensive studies of managed fund investor behaviour, looking at 850,000 retail investors over 30 years (December 1974 to August 2005).

The researchers say that the influence of gender on investing is one of the most robust findings in behavioural finance, confirming the findings of other studies that men are generally more risky, and overconfident.

BT lists the seven deadly sins of investing, which include: pride, lust, greed, envy, wrath, glut­tony and sloth.

There are other managers, too, that produce literature on behavioural finance. Platinum Asset Management has two booklets, including the popu­lar Curious Investor Behaviour, which outlines some cognitive biases.

But few managers take the theory any further. (MIR, a quantitative manager, does use mispricing caused by other investors’ behavioural biases in its process.)

In the US the practical application of behav­ioural finance is gaining momentum. In the March 2005 issue of The Journal of Financial Planning, private wealth director at Hammond Associates, Michael Pompian, and chair of the investment committee at advisory firm, The MDE Group, John Longo, published an article called “Incorporating Behavioural Finance Into Your Practice”.

The article looked at how to incorporate behav­ioural finance into asset allocation design, conclud­ing that advisers are best off adapting allocations to adjust for behavioural finance for wealthier clients, while for those less well off it may be better to try to modify investor behaviour.

The authors believe the future of advising clients will include behavioural finance and advisers will be better able to serve clients’ needs by accept­ing and addressing these issues.

This is a philosophy supported by ipac, which is one of the only advisory firms in Australia to embrace behavioural finance in a practical manner.

Ipac’s Dani believes the next step in the evolu­tion of financial planning is understanding and using the principles of behavioural finance.

“In the past 20 years financial planning has evolved from a sales-based practice, to advice-centric interaction, to lifestyle financial planning. We believe this is the next step in that evolution,” he says.

But the practical application of behavioural finance may take time, as incorporating psychol­ogy and emotions into processes is fundamentally more difficult than the more quantifiable aspects of finance, such as asset allocation or products.

However ipac has approached it in two ways. Through regular workshops, it is educating its plan­ners on behavioural biases and ways to communi­cate those to clients.

“By educating our planners and helping them approach some of these client biases in simple ways it is a very powerful comfort and framework to al­low them to stick to their strategy,” Dani says.

“It can be frustrating as financial advisers, that despite the information, education and communi­cation, clients still react in ways that are contrary to good financial decisions. We saw that in the recent market downturn where every fibre in a client’s body was saying ‘I want to sell’.”

With education of behavioural biases, ipac ad­visers were able to communicate to clients the bias of “loss aversion”, that it is “human” to feel the loss of investments more than the gain. And that instead of comparing investments to recent times it is more beneficial to “anchor” it to a longer-term timeframe.

In addition to educating its advisers, ipac has also made changes to its investment software, particularly for allocated pension clients, which deal with the bias of loss aversion.

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